Is the Fed tightening into a stalling economy?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities*
• Trend Model signal: Neutral*
• Trading model: Bearish*

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


Risk of a policy error are rising
Tim Duy, writing at Bloomberg View, recently observed that the stock market has been behaving roughly as expected during past Fed rate hike cycles. As long as growth is holding up, stock prices should continue to rise, regardless of any perceived valuation excesses:

The general rule is that if the economy continues to grow, then it is more likely than not that stock prices rise, even if the Fed tightens monetary policy. Many analysts, however, continue to resist this historical lesson, largely on the basis of traditional valuation metrics. These metrics, such as PE ratios, have been long elevated, leading to the difficulty explaining market behavior that my Bloomberg View colleague Barry Ritholtz has observed.

But if not market valuations what should be the focus on investors? My view is that they should be watching for signs that, at a minimum, earnings growth will falter or, probably more importantly, that the economy is set to tip into recession. I tend to think it is more likely that the economy takes the equity market down with it than the opposite.

Duy thinks that risks are low and we are not near the tipping point yet:

To be sure, it is impossible to know that the future holds. The chaotic environment in Washington, for example, could erupt into a crisis than threatens the economy. A more likely scenario is that the time will come -- as it always has -- when the Fed tightens policy too much and reverses itself too slowly. That is the most likely event that brings down the economy and equity markets. We just aren’t near that point yet.

I beg to differ. There are early signs that the American economy is starting to stall. These indications, if viewed from a standalone basis, are not cause for concern. But combined with the Fed`s resolve to normalize monetary policy, current conditions could become the basis for a monetary policy error that tips the economy into recession.

The full post can be found at our new site here.